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Temporary Full Expensing: A Quandary for States

Daily Tax Report: State provides authoritative coverage of state
and local tax developments across the 50 U.S. states and the District of
Columbia, tracking legislative and regulatory updates,...

Tax Policy

Federal tax reform may include a move from depreciation to full expensing of business
assets. In this article, the Tax Foundation's Nicole Kaeding discusses how full expensing
at the federal level might impact the states.

By Nicole Kaeding

Nicole Kaeding is an economist at the Center for State Tax Policy at the Tax Foundation.

With the release of the “Big Six” framework for tax reform, states are asking an important
question: How will our revenues be impacted by federal tax reform? Much of that discussion
has focused on the state and local tax deduction, but states should also consider
the impact of full expensing on their budgets.

The Big Six framework calls for full expensing (except for structures) on a temporary
basis of “at least” five years. While many details are missing, we do have some insights
on how this change would impact states. Full expensing would allow corporations to
immediately deduct the cost of any capital expenditures, instead of following complex
depreciation schedules.

Full expensing accelerates economic growth, as the cost of capital is reduced. Full,
permanent expensing could grow the economy by 4 percent over 10 years, raising wages
by more than 3 percent and adding up to 750,000 new jobs nationwide. Now, as my colleague
Kyle Pomerleau has shown in a
recent paper, expensing as envisioned by the Big Six framework is unlikely to deliver as significant
of an impact if it's temporary.

Conformity

The key to understanding how federal tax reform would change state tax codes and revenues
is conformity. For reasons of administrative simplicity, states frequently seek to
conform many, though rarely all, elements of their tax codes to the federal code.
This harmonization of definitions and policies reduces compliance costs for individuals
and businesses with liability in multiple states and limits the potential for double
taxation of income. No state conforms to the federal code in all respects, and not
all provisions of the federal code make for good tax policy. But greater conformity
substantially reduces tax complexity and has significant value.

States tend to conform more on the corporate income tax than the individual income
tax. Forty-one states use federal taxable income, before or after net operating losses,
as their basis of state taxable income.

Ideally, states would fully conform to any federal tax reform that's passed, but states
are following the debate closely, with an eye on their budgets. A true tax reform
package—with broader bases and lower rates—should help increase state revenues. As
the tax base broadens at the federal level, so does it on the state level. While the
federal government plans to use the extra revenues from the expanded tax base to lower
marginal tax rates for individual and corporate income, states set their rates independently.
Without action, state tax revenues could potentially increase overall. If history
is a guide, under that scenario, states are likely to conform to any federal tax changes;
this was the approach they took after the
1986 reforms.

Moving to full expensing, by itself, would likely decrease state revenues, particularly
up front. Deductions for corporations would increase in aggregate as their new investments
are immediately deducted, and expanded capital investment occurs. (The same phenomenon
is true at the federal level too.)

With previous instances where the federal government has accelerated depreciation
rules, states have been hesitant to conform. That's because the changes were not part
of comprehensive reform and would have resulted in a net revenue loss for states.
Within one year of the 2002 bonus depreciation changes, 30 states had limited or decoupled
from those changes.

States Are Quite Cautious

States are quite cautious about conforming to tax changes that limit their revenues.
Unlike the federal government, 49 of the 50 states are governed by balanced budget
requirements, and they budget over much shorter time frames
(typically one or two years) than the 10-year budget window at the federal level.
Small losses of revenue can therefore have a larger impact on the states.

However, the move to full expensing is being considered as part of a broader package,
limiting the risk for states. Other changes to the individual and corporate tax codes,
such as deemed repatriation and the elimination of other deductions, could provide
sufficient revenue to offset any potential revenue loss from moving to full expensing.

Regardless of the revenue impacts, states should strive to conform to changes in expensing
rules with the upcoming federal tax reform. Full expensing is a pro-growth tax change,
which would increase wages and job creation. By not conforming, states would increase
the compliance costs for corporations in their states and limit economic growth potential
within their borders.

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